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The One Thing to Know About Caterpillar

Learn the most important metrics when evaluating a CEO.

I know it sounds ludicrous, but investors often overlook the people in charge of protecting their investments. The idea of gauging a company's leadership plays second-fiddle to other categories of analysis. However, at Fool.com we believe careful study of effective leadership is one of the most important areas of evaluating long-term winning investments.

We like CEOs who actually work for shareholders like us. After all, we're the true owners of the business. When you're deciding whether to invest in a company, failing to vet its CEO is a big mistake. In fact, if you've overlooked the study of a company's leadership, then that's the one important area you should know about before finalizing your investment in the company.

After reviewing thousands of companies over dozens of years, we've found several crucial characteristics of quality management. Today, we'll size up the recent performance of Caterpillar's(NYSE: CAT) leadership.

How much skin do they have in the game?Are Caterpillar CEO Douglas Oberhelman's interests aligned with shareholders? Here's how the Caterpillar CEO's ownership compares to that of other companies in the industry.

CEO, Company

Shares Owned

% of Shares Outstanding

Insider Ownership Market Value (in millions)

Douglas Oberhelman, Caterpillar

83,737

0.01%

$6

Samuel Allen, Deere

57,140

0.01%

$4

T. Solso, Cummins

488,702

0.25%

$39

Mark Pigott, PACCAR

4,412,659

1.21%

$186

Source: Capital IQ, a division of Standard & Poor's. Shares are common stock equivalents only and do not include options, awards, and other forms of compensation.

Oberhelman actually owns $6 million worth of Caterpillar, or 0.01% of shares outstanding. We Fools prefer CEOs who have higher ownership stakes in their businesses, since that better aligns their interests with shareholders'. However, while we think high insider ownership is a good sign, low insider ownership isn't necessarily a bad one. CEOs may be relatively new, or may have a low percent of shares outstanding, but a high total value of ownership. Oberhelman took over as CEO at the start of July, so his low ownership is partially a function of his short tenure in the top spot. While we prefer CEOs with long tenures, Oberhelman has been with the company in various roles for an extended time.

How well are they using your money?Return on equity can help investors determine how adeptly management gets the job done. This metric combines how well management is expanding profitability, managing assets, and using financial leverage, all in one ratio. While return on equity isn't foolproof -- managers can manipulate it with excessive leverage, for example -- it does an excellent job of suggesting how effective managers are, and how well they can generate high returns on investors' capital.

Here's a look at Caterpillar's recent return on equity:

Caterpillar's current return on equity falls below its five-year average. While recent economic conditions have been challenging, declining return on equity shows either that management hasn't been able to control costs and manage assets, or that it's failed to move into higher-return businesses over the last five years. Along with the slowdown in construction, Caterpillar has seen revenues plummet from more than $51 billion in 2008 to around $34 billion in the past 12 months. To the management's credit, Caterpillar managed to stay profitable (on an annual basis) despite this massive sales drop off.

How productive are their workers?Revenue per employee provides another way to gauge a CEO's effectiveness. If this metric is declining, the company might have a bloated organizational structure, or too many extra employees toiling away at new initiatives that just aren't working out. Either possibility would hint that management isn't effectively running the organization.

Source: Capital IQ, a division of Standard & Poor's.

As you can see, Caterpillar's revenue per employee has moved below its five-year average. This might mean that the company's hiring too many people, or spending too much. To better see whether Caterpillar's cost controls are actually deficient, let's compare the company to its peer group once again:

Caterpillar's trailing its peer group in this category over the past five years. Massive revenue drop-offs contributed to this situation. However, with sales rebounding last quarter and cost controls, Caterpillar should show some rebound in this area during 2010.

In the end, management aims to return capital to shareholders, especially if the company can't adequately find new high-growth areas to invest in. So we're pleased to see that:

Dividends have increased by 14.5% annually. The company's current dividend yield stands at 2.6%.

Its outstanding share count has dropped over the past five years. While CEOs are often tempted to retain key talent through lavish stock option awards, this tactic can dilute current shareholders if it's used excessively. If the company's stock isn't overvalued, buying back its own shares is a very tax-effective way to return capital to shareholders.

These are just a few of the factors we look for in a company's management. If you can find leaders who continually give shareholders high returns on their capital, and align their interests with yours, you've got a better chance to enjoy market-beating returns for the long haul.

Jeremy Phillipsowns shares of no companies listed above. PACCAR is aMotley Fool Stock Advisorrecommendation. The Fool has established a bear put spread position on Caterpillar. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.